CHAPTER ACCOUNTING FOR MATERIALS
2:
TOPICS
1. Definition of Materials
2. Systems of Accounting for Materials Issued to Production and Ending
Materials Inventory
3. Control Procedures
4. Methods of Computing Economic Order Quantity
5. Business Papers used to Support Material Transactions
6. Methods of Costing Materials
LEARNING OUTCOMES
1. Distinguish between and account for direct and indirect materials as they
are used in the production process.
2. Differentiate among the forms used in the purchase and issuance of
materials such as purchase requisition, a purchase order, a receiving report,
and a materials requisition.
3. Distinguish between the periodic and perpetual cost accumulation systems
used to account for materials issued to production and for ending materials
inventory.
4. Distinguish among the five common control procedures used to assist
management in keeping inventory costs to a minimum.
TOPIC 1: DEFINITION OF MATERIALS
A material is a substance or mixture of substances that constitutes an object. It
can be pure or impure, living or non-living matter.
Raw materials can be processed in different ways to influence their properties,
by purification, shaping or introduction of other materials.
In industry, materials are inputs to manufacturing processes to produce products
or more complex materials.
TOPIC 2: SYSTEMS OF ACCOUNTING FOR MATERIALS ISSUED TO
PRODUCTION AND ENDING MATERIALS INVENTORY
Either the periodic inventory system or the perpetual inventory system may be
used to account for materials issued to production and ending materials inventory.
Accounting by the periodic inventory system
Under a periodic inventory system, the purchase of direct materials is recorded
in an account entitled “Purchases”. If a beginning materials inventory exists. it is
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recorded in a separate account entitled “Materials Inventory = Beginning” Purchases
added to the materials inventory – beginning will be equal to materials available for use.
Ending materials inventory is determined by a physical count of the materials on hand at
the end of the period. Cost of materials inventory – end. Note that under this method
the cost of materials issued is not directly determined; it is indirectly computed by
deducting the remaining inventory on hand from the total available for use.
Accounting by the perpetual inventory system
Under a perpetual inventory system, the purchase of direct and indirect
materials is recorded in an account entitled “Materials Inventory” rather than in
purchase account. The beginning materials inventory is the balance of the materials
inventory at the end of the precious period. When materials are issued, the Materials
Inventory account is credited for the cost direct materials with a corresponding debit to
the work in process inventory. Issuance of indirect materials is debited to the factory
overhead control account. Under the perpetual inventory system, both the cost of
materials issued and the ending materials inventory can be directly ascertained after
each transaction.
TOPIC 3: CONTROL PROCEDURES
It is utmost importance that a company has a good system of materials inventory
control. Achievement of good control keeps costs a minimum level and plant production
on a smooth, uninterrupted schedule. The following concepts should be employed an
inventory control system.
1. Inventory is the result of purchasing raw materials and part. It is also the result of
applying labor and factory overhead to the raw materials to produce finished goods.
2. Reduction of inventory is the result of normal use and also finding alternative uses for
scrapping unneeded items.
3. Optimum inventory investment is based on quantitative techniques, which are
designed to minimize the cost of carrying inventory and the cost of ordering inventory.
4. Efficient purchasing, management, and investment in materials depend on an
accurate forecast of sales and resulting production schedules.
5. Forecasts help determine when to order materials. Controlling inventory can be
accomplished by scheduling production.
6. Inventory control is more than maintaining inventory records. Control is exercised by
people who are making personal judgments partially on the basis of past experiences
but within the general framework of organizational objectives and policies to achieve
them.
7. Methods of inventory will vary depending on the cost of the materials and their
importance to the manufacturing procedure. Expensive materials and materials
essential to production will tend to have their program for control reviewed more
frequently despite the cost and effort of doing so by experienced personnel.
The total cost of a finished product is composed of the amount spent for
materials, direct labor and share in the factory overhead. It becomes necessary
therefore to adopt a cost control system for each element. The major function, in
general, of any cost control system is to keep expenditures within the limits provided by
a preconceived plan. The control should also encourage cost reductions by eliminating
waste and operational inefficiencies. An effective system of cost control is designed to
control the people responsible for the expenditures because people control costs, costs
do not control themselves.
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COMMONLY USED CONTROL PROCEDURES
Order cycling
It is a method where materials on hand are reviewed on a regular or periodic
cycle, like let’s say every 30 days. The cycle length will differ according to the type of
material being reviewed. Essential or important materials will have a shorter review
cycle than less important items. At the time of the review, an order will be placed to
bring the inventory to a desired level. A technique often used for small items is the 9060-30-day method. When the inventory level drops to a 60-day supply, an order will be
placed for a 30-day supply.
Min-max method
This method is based on the assumption that materials inventory has minimum
and maximum levels. Once the specific minimum and maximum quantities are
determined, the minimum quantity will represent the order point. When the inventory
reaches the minimum level, an order is placed to increase the inventory to the
maximum level. Minimum quantities are usually determined to protect the company
against stock out.
Two-bin method
This method is used for materials that are considered inexpensive and/or
nonessential. The advantage of this method is that it is simple and requires only a
minimum of clerical time. Under these materials are divided and placed into two
separate bins. The quantity of materials that will be used between the time an order is
received and the next order is placed will be on the first bin. The second bin will contain
the quantity of materials that will be used between the ordering and delivery, plus
additional units of safety stock. When the first bin is emptied, an order is placed. The
contents of the second bin will be used until the receipt of the shipment.
Automatic order system
This method is used by most companies that are computerized. An order is
automatically placed when the level of inventory reaches a predetermined order point
quantity. Perpetual inventory record cards are maintained which record purchases and
issuance of the specific materials. When the inventory balance is equal to the
predetermined order point quantity an order is placed. With the use of a computer, it is
possible to periodically recompute the optimum investment in inventory and thus revise
the quantity to be purchased.
ABC plan
This method is used by companies with a large number of materials, each one
having a different value. The materials control for a high-value item will naturally be
different from the material control for a low-value item. The ABC plan is a systematic
way of grouping materials into separate classification and determining the degree of
control that each group requires. For an example, inexpensive or not critical materials
may be accounted for by using the min-max method. For expensive and critical
materials, a more sophisticated method, such as the automatic order system, may be
used.
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MATERIAL CONTROL
Physical Control of Materials
Every business requires a system of internal control that includes procedures for
the safeguarding of assets. Inventories, just like cash and marketable securities, must be
protected from unauthorized use or theft. Inventories usually represent a significant
portion of a manufacturer’s current assets and because of this, materials must be
controlled from the time the order is placed with the vendor until they are shipped to
customers in the finished form. In general, effective control of materials involves.
1. Limited access - only authorized personnel should have access to materials storage
are. All issuance of materials for use in production and release of finished goods for
shipment should be properly documented and approved.
2. Segregation of duties - the following functions should be segregated to minimize
opportunities for misappropriation of inventories – purchasing, receiving, storage, use,
and recording.
3. Accuracy in recording - inventory records should permit the determination of
inventory
quantities on hand upon request, and cost records should provide the data for the
valuation of inventories for the preparation of financial statements.
TOPIC 4: METHODS OF COMPUTING ECONOMIC ORDER
QUANTITY
Controlling the investment in materials
One of the most important objectives of materials control is maintaining the
proper balance of materials on hand. An inventory of sufficient size and diversity for
efficient operations must be maintained, but the size should not be excessive in relation
to scheduled production needs. The planning and control of the materials inventory
investment requires careful study of the following factors usage of funds costs of
materials handling storage, and insurance against fire, theft, or other casualty, lost from
damage, decoration, and obsolescence. These factors should be considered in
determining (1) when orders should be placed and (2) how many units should be
ordered.
Order point
A subsidiary ledger must be kept for each individual item of raw material used in
the manufacturing process. This ledger will indicate the inventory on hand for each
item. The point at which an item should be ordered called the order point occurs when
the predetermined minimum level of inventory on hand is reached. Calculation of the
order point is based on the following data:
1. Usage – the anticipated rate at which the materials will be used.
2. Lead time - the estimated time interval between the placement of an order and
receipt
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of the material.
3. Safety stock - the estimated minimum level of inventory needed to protect against
running out of stock.
Assume that the expected daily usage of an item of material is 100 units, the
anticipated lead time is 4 days, and it is estimated that a safety stock of 800 units is
needed. The following calculation shows that the order point is 1,200 units
100 units (daily usage) x 4 days (lead time)
400 units
Safety stock
800 units
Order point
1,200 units
Economic order quantity
The purchased order which results in the minimum total inventory cost. In
determining the quantity to be ordered, the cost of placing an order and the cost of
carrying inventory must be considered.
A. Factors to be considered in determining ordering costs
1. Salaries and wages of employees engaged in purchasing receiving, and inspecting
materials.
2. Communication costs associated with ordering, such as telephone, postage, and
forms
of stationery.
3. Materials accounting and record keeping.
B. Factors to be considered in determining carrying costs
1. Materials storage and handling costs.
2. Interest, insurance, and property taxes.
3. Loss due to theft, deterioration, or obsolescence.
4. Records and supplies associated with the carrying of inventories.
METHODS OF COMPUTING ECONOMIC ORDER QUANTITY
1. Tabular method – under this method, several purchase order quantity alternatives
are listed in separate columns. Total inventory costs, showing both carrying and
ordering costs are calculated for each alternative. The column with the lowest total
amount of inventory cost will be the economic order quantity.
The economic order quantity can also be determined by constructing a table as
shows below.
Order Size
No. of
Orders
Total Order
Cost
Average
Inventory
100
100
P1,000
50
300
33
P330
150
500
20
P200
250
700
14
P140
350
900
11
P110
450
EOQ = 500 UNITS (ORDER SIZE WHERE TOTAL COSTS = 400)
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Total
Carrying
Cost
P40
P120
P200
P280
P360
Total Order
& Carrying
Cost
P1,040
P450
P400
P420
P470
Order size
No. of orders
Total order cost
Average Inventory
Total carrying cost
Total order & carrying cost
= number of units per order
= 10,00/order size
= No. of orders x P10 per order
= Order size/2
= average inventory x P0.80
= Total order cost + Total carrying cost
Total ordering costs and total carrying costs vary inversely. The greater the
inventory on hand, the greater the total carrying costs but the lower the ordering costs.
If a small inventory is on hand, total carrying costs will be lower but more orders will be
placed, thus increasing the total ordering costs. It is the responsibility of management to
find the proper inventory policy that keeps the total inventory costs (total carrying costs
+ total ordering costs) to a minimum.
2. Formula method - the formula method is easy to use and it produce an exact figure.
The formula that can be used is:
Illustrative problem 1
To illustrate the application of the formula, let us assume the following:
Number of units of materials required annually
Cost of placing an order
Annual carrying cost per unit of inventory
10,000
P 10.00
P 0.80
Using the EOQ formula:
Order Point
Once the Economic Order Quality has been determined, management must
decide when to place the order, the order point must be established. If the lead time
and the inventory usage rate are known, determination of the order point is easy. Lead
time is the period between the placement of the order and the receipt of the materials
ordered. Inventory usage rate is the quantity of materials used in production over a
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period of time. The order point should be where the inventory level reaches the number
of units that would be consumed during the lead time.
Illustrative problem 2
Assume that the expected daily usage of an item of material is 100 units and the
anticipated lead time is 4 days. The following calculation shows that the order point is
400 units.
Order point
= 100 units (daily usage) x 4 days (lead time)
= 400 units
When the inventory level of materials is reduced to 400 units, an order should be
placed for 500 units (the EOQ).
Safety Stock
Since it is almost impossible to estimate lead time and average usage rate with
accuracy, many companies prefer to carry a safety stock (or additional inventory) as a
cushion against possible stock outs. In such a case, the order point is computed by
adding the safety stock to the estimate usage during the lead time. A safety stock
calculation should arrive at a figure which properly balances the risk of a stockout
against the additional carrying costs incurred by the extra inventory.
Illustrative problem 3
Assume the use of same data as in the computation of the order point above
(without the safety stock) the revised order point may be computed as follows assuming
safety stock of 800 units.
100 units (daily usage) x 4 days (lead time) 400 units
Safety stock
800 units
Revised order point
1,200 units
Illustrative problem 4
A television manufacturer buys wooden cabinet from outside suppliers at P 400
per set. Total annual needs are 5,000 units at a rate of 20 sets per working day. The
following cost data are available.
Desired annual return on inventory investment (10% x 400)
Rent, insurance, taxes per unit per year
Carrying cost per unit per year
Cost per purchase order – clerical costs, supplies, telephones, etc.
Requirements:
1. What is the economic order quantity?
2. Compute for:
a. Annual ordering costs
b. Annual carrying costs
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P 40
10
P 50
P 50
TOPIC 5: BUSINESS PAPERS USED TO SUPPORT MATERIAL
TRANSACTIONS
Purchase requisition
It is a written request, usually sent inform the purchasing department of a need
for materials or supplies. The purchase requisition is usually preprinted according to the
specifications of a particular company. Most forms usually include the requisition
(serially numbered) name of the department or individual making the request, quantity
of items requested, description of the item, unit price, order data, required delivery
date, and authorized signature.
The company requisitioned 600 units of Materials A. two copies of the purchase
requisition are customarily made, the original going to the purchasing department (to
place the order) and the copy remaining with the storeroom clerk who requested the
purchase order (to keep track of orders placed)
Purchase order
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It is a written request to a supplier for specified goods at an agreed upon price.
The request also stipulates terms of delivery and terms of payment. The purchase order
is the supplier’s authorization to deliver goods and submit a bill. All items purchased by
a company should be accompanied by purchase orders, which are serially numbered to
provide control over their issuance. The following items commonly included in a
purchase order are preprinted name and address of company placing the order,
purchase order number, name and address of supplier, order date, date delivery is
requested, delivery and payment terms, quantity of items ordered, description, unit and
total price, shipping, handling, insurance and related costs, total cost of entire order,
and authorized signature. If the purchase requisition is properly completed, the
purchasing department will issue a purchase order (in this case, for 600 units of Material
A). figure 6-2 below shows a purchase order. The original is sent to the supplier (to place
the order) copies usually go to the accounting department (for future recognition in the
purchases journal and the general and subsidiary legers), to accounts payable, (for
eventual payment within the discount period), to the receiving department (to alert
them to expect a delivery), and a copy is kept by the purchasing department (to
maintain a file of all purchase orders issued).
Receiving report
When the goods that were ordered are delivered, the receiving department will
unpack and count them. It is interesting to note that the quantity ordered is not shown
on the copy of the purchase order sent to the receiving department. This deliberate
omission ensures that the goods delivered are actually counted. The goods are checked
to be sure that they are not damaged and that they meet the specifications of the
purchase order. This form includes the supplier’s name, purchase order number, date
delivery was received, quantity received, description of goods, discrepancies form the
purchase order (or mention of damaged goods, and authorized signature.)
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The original copy of the receiving report is kept by the receiving department.
Copies are sent to the purchasing department (to indicate the order was received) and
to the accounts payable department (to be matched against the purchase order and the
supplier’s bill). If all three agree, payment is authorized. Copies are also sent to the
accounting department (to journalize and post the purchase and the related liability)
and to the storeroom clerk who originated the purchase requisition (to give notice that
the goods have arrived). A copy also accompanies the materials to the storeroom.
Materials requisition slip
It is a written order to the storekeeper to deliver materials or supplies to the
place designated or to issue the materials to the person presenting a properly executed
requisition. Each material requisition form shows the job number or department
requesting the goods, their quantity and description, and the unit cost and total cost of
the goods, their quantity and description, and the unit cost and total cost of the goods
issued. The cost that is entered on the materials requisition is the amount charged to
production for materials consumed.
TOPIC 6: METHODS OF COSTING MATERIALS
The main objective of cost accounting is to produce accurate and meaningful
figures for the goods manufactured and sold which are to be used by management for
control, analysis and for the determination of the operating income.
These methods are related to the flow of costs and not necessarily to the actual
flow of materials or finished goods. If only the materials were acquired at the same cost
all year round, then valuation of materials inventory, end, will not be a problem because
the value can be computed by simply multiplying the units on hand and the unit cost.
The same can be said for the finished goods because if the units were produced at the
same cost all year round the value at the end of the period can be computed by
multiplying the finished goods on hand by the cost to produce each unit. The different
methods are used because the materials are acquired at different costs during the year.
Average cost for perpetual inventory system refers to moving average and for periodic
inventory system – weighted average.
First-in, first-out (FIFO) method of costing
The first-in, first-out (FIFO) method is based on the assumption that cost should
be charged to manufacturing cost or cost of goods sold in the order in which incurred.
Inventories are stated in terms of the recent costs and expense is charged with the
earliest costs incurred.
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Illustrative problem:
August 1
12
16
18
20
25
28
Inventory 400 units at P10
Purchased 600 units at P12
Issue 500 units
Purchase 300 units at P15
Issue 200 units
Purchase 400 units at P14
Issue 400 units
P 4,000
P 7,200
P 4,500
P 5,600
The inventory on August 31 show 600 units on hand. Under periodic inventory
system, the most recent costs would be assigned to the units as follows:
From Aug. 25 purchase 400 units at 14
From Aug. 18 purchase 200 units at 15
Total
600
P 5,600
P 3,000
P 8,600
If the ending inventory is valued at P 8,600, cost of materials issued is P 12,700
computed as follows:
Materials, Aug. 1
Purchases (7,200 + 4,500 + 5,600)
Total available for use
Less: Materials, Aug. 31
Direct materials used
P 4,000
P 17,300
P 21,300
P 8,600
P12,700
When perpetual inventory system Is used, a stock card is used to record the
costs assigned to units issued and to the units on hand.
As shown on the issued section of the stock card on page 171, the cost of
materials issued is:
400 at P 10.00
P 4,000
100 at P 12.00
P 1,200
200 at P 12.00
P 2,400
300 at P 12.00
P 3,600
100 at P 15.00
P 1,500
1,100
P 12,700
The value of units on hand, August 31 using perpetual inventory system is the
same as that computed under period inventory system. The amount is computed as
follows:
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200 at P 15.00
400 at P 14.00
600
P 3,000
P 5,600
P 8,600
Average Method
1. Weighted average method – used for periodic inventory system. This method is
based on the assumption that units issued should be charged at an average cost, such
average being influenced or weighted by the number of units acquired at each price.
The inventory at the end is computed by multiplying the weighted average cost per unit
by the units on hand. Using the illustrative problem on page 56, the weighted average
unit cost is computed as follows:
400 units at P 10.00
600 units at P 12.00
300 units at P 15.00
400 units at P 14.00
1,700
P 4,000
P 7,200
P 4,500
P 5,600
P 21,300
Weighted average unit cost = 21,300
1,700
=12.529
Inventory, August 31 (600 units x P 12,529) = P7,517.65
2. Moving average method – when a perpetual inventory system issued, a new
weighted
average unit cost is calculated after each new purchase, and this amount is used to cost
each subsequent issuance until another purchase is made.
The computation of the unit cost is as follows:
Aug. 12
Balance
400 at P 10.00
Purchase
600 at P 12.00
1,000
P 4,000
P 7,200
P 11,200
The new weighted average unit cost = P 11,200
1,000 units
= P 11.20
Aug.18
Balance
500 at P 11.20
12
P 5,600
Purchase
300 at P 15.00
800
P 4,500
P 10,100
The new weighted average unit cost = P 10,100
800 units
= P 12.625
The cost of materials issued may be computed from the data presented under issued
section.
500 units at P 11.20
P 5,600
200 units at P 12.625
P 2,525
400 units at P 13.175
P 5,270
1,100
P 13,395
Comparison – FIFO and Average Methods
FIFO AVERAGE
Inventory
P 4,000
Purchases
P 17,300
Total available for use
P 21,300
Less: Inventory, Aug. 31
P 8,600
Direct materials used
P12,700
13
P 4,000
P 17,300
P 21,300
P 7,905
P 13,395